Should the top marginal income tax rate be 73 percent?

When they won the 2011 Nobel Prize in economics for their research on the causes and effects of government policy on the macroeconomy, Thomas Sargent and Christopher Sims were given a unique opportunity to connect their academic work to actual government action. They had spent their professional lives studying macroeconomic policy,and here we were in the middle of a macroeconomic crisis with the entire policymaking world anxious to hear what they had to say. How do tax cuts affect GDP? How should the government respond to sluggish growth and a terrible labor market? Might we experience serious inflation? Is fiscal stimulus effective? Everyone was listening — now was Sargent and Sims’ chance to let the world know their policy prescriptions.

The first questions the press asked the new laureates went right to the heart of the matter: Had the U.S. government responded appropriately to the Great Recession and what should it do to create jobs and support the economy?

Sims’ answer was fascinating:

I think part of the point of this prize in the area that we work in is that answers to questions like that require careful thinking, a lot of data analysis, and that the answers are not likely to be simple. So that asking Tom [Sargent] and me for answers off the top of our heads to these questions — you shouldn’t expect much from us. My own view is that what we ought to do is the kind of thing that Chairman Ben Bernanke has urged the U.S. government to do: make good long-run plans for resolving our budget difficulties without imposing severe fiscal stringency in the short-run and that accommodative monetary policy is a good idea. But these are not very original ideas. I think 80 percent of the economics profession would agree with this. The problem is to figure out how in the real world to get these things done.1

His answer echoed his response in another interview, quoted in The New York Times: “‘The methods that I’ve used and that Tom [Sargent] has developed are central for finding our way out of this mess,’ [Sims] said. But asked for specific policy conclusions of his research, he responded, ‘If I had a simple answer, I would have been spreading it around the world.'”2

Those answers are a model of how academic economists should behave when facing questions about specific policy. It is extremely difficult to take the results in an academic journal article and apply them to real-world policy questions because the method used in much of economics research is to start with assumptions and to derive conclusions from them. Much of economics research is a series of if-then statements. But as economists readily admit, the ifs are often wildly incorrect. That is not a problem for academic research, in which all results come with a long list of caveats and in which readers are professional economists who spend years in PhD programs learning the caveats. But it does present a problem for economists who try to base specific real-world policy prescriptions on highly stylized models.

Peter Diamond, also a Nobel laureate, and Emmanuel Saez, both eminent and widely respected economists, agree. In a 2011 essay on tax policy they wrote, “When done well, moving from mathematical results, theorems, or calculated examples to policy recommendations is a subtle process.”3 Diamond and Saez have outlined three conditions under which “a theoretical result can be fruitfully used as part of forming a policy recommendation”:

First, the result should be based on an economic mechanism that is empirically relevant and offirst order to the problem at hand. Second, the result should be reasonably robust to changes in the modeling assumptions. … Third, the tax policy prescription needs to be implementable — that is, the tax policy needs to be socially acceptable and not too complex relative to the modeling of tax administration and individual responses to tax law. By socially acceptable, we do not mean to limit the choice to currently politically plausible policy options. Rather, we mean there should not be very widely held normative views that make such policies seem implausible and inappropriate at pretty much all times.

Having established those conditions, they then argue that their policy recommendation of significantly higher income taxes on the country’s top earners — summarized in an influential Wall Street Journal op-ed essay — satisfies them.4

We disagree. We do not believe that their model can be used prudently as the basis for the real-world public policy problem of determining the socially optimal top marginal income tax rate.5

5 We focus on the taxation of labor income. In their Journal of Economic Perspectives 2011 essay and Wall Street Journal op-ed, Diamond and Saez called for increasing tax rates on capital income as a way to reduce tax avoidance opportunities. While there are many arguments against higher taxes on capital, they are outside the scope of this essay, as capital taxation is of secondary importance in Diamond’s and Saez’s recommendation.

For a complete listing of all On the Margin articles, please visit: www.aei.org/onthemargin/.